Over Indebtedness, Over Promise, Over Capacity

Today I would like to share with you my response to a request from Agora Financial in the US for my outlook for 2015.

Overarching theme

There are three key issues confronting the global economy:

Over indebtedness

Over promise

Over capacity

Reaching this stage of excess has been several decades in the making.

The abandonment of the gold standard in 1971 fired the starter’s gun on the greatest credit binge in history.

The global debt to GDP ratio table tells the tale of the private sector’s (in the developed world) lack of restraint in the debt accumulation stakes.

Source: Geneva Report

Credit funded consumerism combined with an expanding middle class were the primary drivers of the new economic growth model. Everything radiated from this core.

Banks prospered and became more creative in their credit offerings — to the extent we now have ‘too big to fail’ institutions.

Governments promised more entitlements on the back of increased tax revenues.

Manufacturing expanded to cope with increased credit funded demand.

The investment industry grew rapidly to satisfy investor demand to participate in the new world of continuous prosperity.

In the developed world, we have created a world of expectation. We expect to have employment…especially if we have tertiary education. We expect government to provide benefits. We expect access to healthcare. We expect to retire in our mid-60s either independently or with government assistance. We expect investment markets (property, shares, commodities and bonds) to treat us favourably over the longer term. We expect inflation.

We do not expect government to renege on their social contract. We do not expect investment markets to fail to deliver. We do not expect deflation. We do not expect the next 40 years to be fundamentally different from the past 40 years.

Very few people seem to grasp the fact that today and tomorrow’s income is being committed to yesterday’s liabilities.

For the private sector to undertake the same level of liabilities as they have is unlikely without substantial wages growth, employment security, and/or even lower interest rates.

Without the high octane fuel of consumer debt, the economic engine is misfiring, spluttering and stalling. Some cylinders (US and China) have the pistons moving…albeit not as rapidly as a decade ago. In other cylinders (Europe and Japan) the pistons have all but seized.

Globalisation means interconnectedness. The repayment, retirement and reluctance of Western consumers is evident in the continued downward revisions of the IMF’s growth numbers.

As growth rates continue to feel the squeeze, regions are adopting a ‘beggar thy neighbour’ approach to capture a bigger slice of a shrinking economic pie for themselves. The intensity of the currency war is set to increase significantly as social unrest manifests itself at the ballot box.

For six years (and counting) central bankers have built a levee made of paper and suppressed interest rates to hold back the surging tide of private sector credit contraction. In my opinion, the forces behind the tidal surge will eventually prove too powerful for the central bankers’ levee.

It’s against this background that I’ve formulated my views on the following areas.

Commodities in 2015

First, let me say that one of the risks of forecasting is to extrapolate the past into the future.

Predicting the direction of each one of these is beyond my capabilities. However, on the key commodities — iron ore, copper, natural gas and oil — my expectation is the past price action is likely to continue this year.

We have world of increased supply meeting one of decreased demand. Eventually, price equilibrium will be restored but only after supply decreases or demand increases or a combination of both. The more probable scenario is for supply to decrease as marginal players close up shop.

In the fight for survival, producers are inclined to lower prices to generate cash flow. My expectation is for lower commodity prices this year. This outcome only adds to the deflationary scenario we are facing.

China’s outlook

The slowing growth rate in China is a function of globalisation and domestic imbalances — a result of massive debt funded infrastructure spending.

Like the rest of the world, China believed at some point during the past six years the Western consumer would revert to type and the growth engine would once again purr into action. China backed this belief with a full throttle approach to infrastructure investment.

China has built it, but no one (at least not to the numbers they need to service the debt) has come.

To achieve this objective China needs to create its own internal demand. Eventually, this will happen, but not in 2015.

In the interim, the continued retreat of the Western consumer and the challenge of stabilising an economy that has leveraged up 25x in 15 years will further slow China’s economic progress. In due course, China is set to register growth numbers beginning with a three.

Europe, Draghi, stagnation

The Eurozone had merit in the good times. There was enough to go around for everyone. The resultant stresses from the Great Credit Contraction are going to place European relationships under further pressure.

The ‘beggar thy neighbour’ approach should come to the fore as Europe’s politicians begin to identify with the growing social unrest. The binds tying the union together are not strong enough to withstand the sustained financial pressure a deflationary world is going to apply.

The break way could be an unknown such as Hungary. The Hungarians have austerity fatigue and a large percentage of loans in Swiss francs.

My long held belief is there will be a sovereign default (fully or partially) to relieve internal budgetary pressures.

Draghi is weak. The not-so-super Mario will do what he’s told.

If you saw the thinly veiled look of disgust on (IMF chief) Christine Lagarde’s face when asked about the Swiss abandoning the euro peg, you know Mario will jump as high as Christine tells him to.

Memo to Mario: follow the central banker rulebook, or else look for another bureaucratic job with less pay. Draghi will do whatever it takes…to keep his job.

Margaret Thatcher famously said ‘the problem with socialism is you run out of other people’s money.’ A stagnating, socialist leaning Europe is about to find out how true this is.

Governments have over-promised — pensions, jobs for life, healthcare — on a belief that the world would continue to supply an abundance of tax dollars to finance these grand schemes of delusion. A deflating Europe has a world of pain in store for politicians, constituents and bondholders.

Right up to the point when the brick wall of reality is about to crush them, the ECB could adopt a form of Abenomics — fully underwriting member budget deficits. The madness of desperate policymakers knows no bounds.

Therein lies the problem with predictions: Underestimating the level of (in equal measures) stupidity and desperation central bankers are destined to plumb in their efforts to recreate consumption habits of a bygone era.

In a normal world, Japan should have pleaded for the mercy of the bond market. However in this abe-normal world, what happens next and for how long is anyone’s guess. You know it’ll end badly, but you’re not quite sure which torturous path it’ll take.

For now the ECB has a 19-month commitment to its newly announced QE. Depending on what happens with Greece and whether there are any other murmurings of discontent, the timeframe and the quantum of euros printed are elastic.

In a world with slowing growth, Europe is caught in a socialist bind of its own making. This will not end well.

The Fed’s potential actions this year

A deflating and fracturing Europe means no interest rate increases from the Fed in 2015.

Here’s a left field possibility, the Fed may actually move interest rates into negative territory (like the Swiss) to take some of the strength from the US dollar…due to the scramble for dollars to pay down USD denominated debt.

My view is the US share market (after six straight years of positive returns) is that it’s in for a serious correction. Depending upon the severity of the market downturn, Yellen may feel the heat to start another round of QE to recreate the so-called ‘wealth effect’.

In a nutshell — interest rates will stay the same or go down. QE four or five (what number are we up to now?) has a 60% chance of being rolled out.

Thoughts on Australia

A slumping China means more pain for our mining sector.

More marginal miners will close operations in 2015. Banks are already increasing their bad debt provisions to the mining sector.

Higher unemployment beckons from the resources slowdown together with the softening in global growth.

A hostile and financially irresponsible senate means the federal government runs larger budget deficits than originally projected.

The official cash rate is destined to fall below 2%, perhaps into the low 1% range.

Judging by the public backlash to governments that have had the temerity to tackle debt issues, it appears our political masters have been put on notice by an electorate that has very little appetite for unfunded promises to be scaled back.

Australia dodged the worst of the GFC for two reasons:

China’s full throttle response to infrastructure spending was a huge boon to our resource sector.

Federal government debt was non-existent.

Australia will not be so fortunate when the next crisis lands on our shores.

China’s decision to ease up on infrastructure spending and transition to a more consumption based economy means the resource sector will not play the role of the ‘white knight’.

In the space of seven years, the federal government has gone from being $20 billion in the black to $390 billion in debt.

As a percentage of GDP, this is relatively modest by international standards, but it is of a sufficient level that the government has to be more considered in its stimulus responses…unless of course it goes down the path of the US, Europe, UK and Japan.

Summary

At some point, over indebtedness will lead to massive debt write-offs (defaults). This will result in serious financial pain for investors holding the debts — bondholders and bank shareholders.

Governments will renege on their social contract regarding entitlements for life. The social upheaval from those ill-equipped (distinct from those who are too sick, old or disabled) to generate income independently will create a troubling and unsettled social mood. A depressed social mood will be reflected in the prices investors are prepared to pay for assets — shares and property.

Finally, over capacity will be resolved initially by producers filing for bankruptcy or simply closing the doors on their loss making enterprises. In due course, the remaining producers will benefit from the gradual consumption uptake from China, and in due course, India.

Over indebtedness, over promise and over capacity have put us all over a barrel. This is a bad situation that has to be worked through. We cannot avoid or solve this with printed paper or suppressed interest rates.

I really appreciate your solid and relevant articles. My question is, Having a substantial amount of my portfolio in cash, is there a risk that if a 90% stock market correction occurs, my cash would be vulnerable? If so what can I do? and are building societies safer?

Kind regards
Andrew

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2 years 10 months ago

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